Commencement of Lease term, Minimum Lease Payments, Fair Value Ind AS 17

At the commencement of the lease term, lessees recognise finance leases as assets and liabilities in their statements of financial position at amounts equal to the fair value of the leased property or, if lower, the present value of the minimum lease payments, each determined at the inception of the lease.

Any initial direct costs of the lessee are added to the amount recognised as an asset. Minimum lease payments are apportioned between the finance charge and the reduction of the outstanding liability. The finance charge is allocated to each period during the lease term so as to produce a constant periodic rate of interest on the remaining balance of the liability. Contingent rents are charged as expenses in the periods in which they are incurred. A finance lease gives rise to depreciation expense for the recognised lease assets as well as finance expense for each accounting period.

“At the inception of the Lease, the present value of Minimum Lease Payment amounts to at least substantially (i.e. at least 90%) all of the fair value of the leasehold land”.

In case the above condition is fulfilled, the lessee should present the leasehold land under “Property Plant and Equipment”.

Further, if there is reasonable certainty that the lessee will obtain ownership at the end of the lease term then the land shall not be depreciated else shall be depreciated over the lease term or useful life whichever is lower.

For the purpose of classification of Land and Building separately, following methods are followed:

• The Minimum Lease Payments (including lumpsum upfront payments) are allocated between the land and buildings in proportion to the relative fair values of the leasehold interest in the land and building at the inception of lease.
• If the lease payments cannot be allocated reliably, the entire lease is classified as a finance lease unless it is clear that both elements are operating lease, in which the entire lease is classified as an operating lease.
• If the land value is immaterial, the land and building may be treated as a single unit for the purpose of lease classification. In such case the economic life of the building is regarded as the economic life of the entire leased asset.

Finance lease accounting

Initial accounting

The initial accounting is that the lessee should capitalise the finance leased asset and set up a lease liability for the value of the asset recognised. The accounting for this will be:

Dr Non-current assets

Cr Finance lease liability

(This should be done by using the lower of the fair value of the asset or the present value of the minimum lease payments.)

Note: The present value of the minimum lease payments is essentially the lease payments over the life of the lease discounted to present value you will either be given this figure in the Paper F7 exam or, if not, use the fair value of the asset. You will not be expected to calculate the minimum lease payments.

Subsequent accounting

Depreciation

Following the initial capitalisation of the leased asset, depreciation should be charged on the asset over the shorter of the lease term or the useful economic life of the asset. The accounting for this will be:

Dr Depreciation expense

Cr Accumulated depreciation

When a company pays a rental, in effect it is making a capital repayment (ie against the lease obligation) and an interest payment. The impact of this will need to be shown within the financial statements in the form of a finance cost in the statement of profit or loss and a reduction of the outstanding liability in the statement of financial position. In reality there are several ways that this can be done, but the Paper F7 examiner has stated that he will examine the actuarial method only.

The actuarial method of accounting for a finance lease allocates the interest to the period it actually relates to, ie the finance cost is higher when the capital outstanding is greatest, but as the capital gets repaid, interest payments become lower (similar to a repayment mortgage that you may have on your property). To allocate the interest to a specific period you will require the interest rate implicit within the lease agreement again this will be provided in the exam and you are not required to calculate it.

One of the easiest ways to apply the actuarial method in the exam is to use a leasing table. Please take note of when the rental payment is actually due, is it in advance (ie rental made at beginning of the lease year) or is it in arrears (ie rental made at the end of the lease year)? This will affect the completion of the lease table as highlighted below: